India's biggest bank State Bank of India drove the banking rally on Wednesday, following an announcement on recapitalisation of state-owed banks. The National Stock Exchange (NSE) PSU Bank Index rose as much as 24% intraday, led by an all-round gains by the top public sector banks.

On Tuesday evening, the government announced Rs 2.11 trillion for PSU bank recapitalisation to enable them to revive lending and grow their businesses. Most PSU banks have been reeling under bad loan and its attendent provisions in their balance sheets, which has forced them to curtail lending.

The rally on Wednesday was led by Punjab National Bank (PNB) which jumped 46% intraday, while SBI rose 27%and Bank of Baroda rose 31.5% each. The gains were across the board with even the likes of loss making IDBI Bank gaining a smart 16%. The sudden surge in stock prices indicate that the market had not anticipated this move by the government.

SBI's market capitalisation Rs 60,000 crore in a day's trading. HDFC Equity Fund, Reliance Equity Opportunity and ICICI Prudential Focused Bluechip Equity are the top three mutual fund that own SBI.

Of the Rs 2.11 trillion commitment by the government, Rs 1.35 trillion will come from the sale of recapitalisation bonds. Another Rs 18,000 crore will come from budgetary support and the balance Rs 58,000 crore through fundraising through share sales from the markets.

Indian banks are sitting on gross NPA of approximately Rs 8.5 lakh crore and net NPA of Rs 4.8 lakh crore and quite a few state-run banks are actually sitting on negative net worth. Hence, recapitalisation is a first step in the resolution process to get them on even keel. Edelweiss Securities Ltd said that the strong booster entails lower systemic risk as it will ease PSU banks’ capital deficiency; while it could encourage lending.

“While the government’s capital allocation formula will be key, we anticipate leading banks to be in a better bargaining position to command higher capital to meet Basel requirements and participate in growth. On the flip side, it could potentially entail higher dilution risk,” the brokerage firm said in a note written shortly after the announcement was made.

In the year so far, NSE PSU Bank index has surged 27%, while NSE Private Bank index is up 35%. Benchmark indices Sensex and Nifty jumped 19-22% in the same period.

Welcoming the government’s decision, Reserve Bank of India governor Urjit Patel said that for the first time in a decade, there is a comprehensive and coherent policy, rather than piecemeal strategy, to tackle the issues of the banking system.

While analysts welcomed the move, they feel that in the medium-term while resolution of NPA will gather momentum, banks will likely adhere to greater provision requirements of the RBI (hence profitability may not look up). They also expect banks compete a more aggressively in the credit market (hence, expect pressure on margin to get aggravated).